Good-Bye to the Golden Age of Options

The golden age of stock options is over. Just ask Russell Posner. As senior director of corporate compensation at Merck & Co., Posner oversees the $22.5 billion global pharmaceutical company’s executive and stock-based pay programs. For the past year and a half, he has grappled with how to comply with imminent accounting-rules changes mandating that public companies expense stock options and yet still provide a competitive long-term equity compensation program for executives and other employees.

Rules from the Financial Accounting Standards Board requiring companies to recognize the cost of stock-option grants on their financial statements aren’t due until the end of the year and won’t take effect until 2005 or later. But Merck didn’t wait. Since spring 2003, Posner’s department has polled employees, proposed a new plan that includes restricted stock and performance-based stock as well as options, implemented changes, and spread the word to employees through e-mail memos and face-to-face seminars.

The outcome: this year, Merck switched 4,000 of 55,000 employees worldwide previously eligible for stock options to the new program. Another 1,100 will make the jump in 2005, and more after that. Merck isn’t expensing options yet, and officials at the company, which is located in Whitehouse Station, New Jersey, haven’t publicly stated what effect the revamped program has had on earnings. But employees have embraced it. "We have employees asking to be included," Posner says.

For years, options were the long-term incentive of choice for everything from Internet start-ups to established old-industry conglomerates. But they aren’t the carrots they once were, and not just because of accounting changes. For the past few years, options at many companies have been underwater--grant prices exceeding what the stock currently trades for--making them a less attractive job perk. Options have also come under fire from shareholders, whose holdings have been diluted as companies issued more shares to fund present and future employee grants.

As a result, companies are shying away from options. Many are curbing the amounts they grant, or limiting who is eligible, or both. Employees could see their yearly options reduced as much as 40 percent, according to a recent survey by Mercer Human Resource Consulting. "Companies are making tougher calls; they’re going to really target their A players," says Russell Miller, a Mercer senior executive compensation consultant in New York.

Lower-level employees will bear the brunt of the cuts, according to a July survey from Mellon Financial, which polled 108 companies with a median size of $1.1 billion. "When they look to cut costs, where’s the first place they’re going to look? Not at the top-five [officer] level, but across the rank and file," says Ted Buyniski, a principal with Mellon’s compensation consulting practice in Boston.

What works for one company isn’t necessarily the best for another, Buyniski says. "Because of the way the expensing rules are structured, every company has to look at their costs in the context of their business versus their industry or sector," he says. Whatever they choose, the transition is keeping corporate compensation departments on their toes. Compensation directors should be analyzing what the cost of continuing an existing program would be, and what they could do to deliver a comparable perceived value at a lower cost, or whether their programs are already structured to do that, Buyniski says. "The storm is coming, and they need to make sure their people stay dry."

"Companies are making tougher calls; they’re going to really target their A players."

In place of options, some companies are offering other equity compensation, such as restricted stock units, which are grants of shares that vest at the end of a given period if an employee remains on staff. Employers are also adding performance-based shares, grants that vest only if the company meets certain performance targets over a given period. In 2004, for example, Eastman Kodak Co. is granting so-called "leadership stock" to 800 executives that will pay out in 2007 if the company hits certain earnings-per-share numbers in 2006.

Other companies are steering away from equity incentives altogether, giving employees salary increases or bonuses, or larger contributions to a 401(k) program. In December 2003, Pepsico Inc. overhauled its long-term compensation program when it began expensing options. As part of the redo, Pepsi cut by approximately 50 percent the number of stock options it issues to employees under its 15-year-old PowerShare program in order to fund a new 401(k) plan match of Pepsi stock. At the same time, Pepsi cut stock grants to executives in order to fund a new long-term cash bonus for them, and said it would give managers the choice of receiving grants as options or restricted-stock units. In fiscal 2003, before the changes took effect, Pepsi reported that options cost $510 million, or about 20 cents a share, the equivalent of 10 percent of the company’s $2.05-per-share earnings for the year.

Managers at Merck began reviewing its long-term incentive program in early 2003 by putting together an ad hoc committee of executives from the legal, finance, tax, employee stock administration, human resources and communications departments to work with Posner and the compensation group. Their directive: come up with a new program to keep Merck’s share-based pay level with that of pharmaceutical-industry competitors and other companies its size, keep employees happy and minimize costs when the time comes to expense options.

The group’s first step was an online poll of 26,000 U.S. employees on long-term incentives: Did they like options? Were there other things they’d rather have? In all, 12,000 employees responded to the fall 2003 survey, a number Posner calls "very high." At the time, several of Merck’s most recent options grants were underwater, and poll data showed strong support for adding other equity incentives. The ad hoc committee complied. They restructured the long-term compensation plan so that beginning in 2004, Merck’s top 200 executives globally would be eligible to receive a mix of options, performance-based shares pegged to growth over a three-year period, and restricted stock units, also with a three-year vesting period, with one given for every three previously granted options. A lower tier of 3,800 U.S. managers who previously were eligible for options only would be eligible for a mix of 75 percent options and 25 percent RSUs.

Merck didn’t need shareholder approval for the changes, which were covered under an existing omnibus stock plan. But the company’s board was required to sign off, which it did in late 2003, after clearing it with an outside compensation consultant.

Because public companies are already required to expense performance-based shares and RSUs, the change wasn’t cost-free, though Merck hasn’t publicly disclosed the expenses on earnings. "There’s an impact on our bottom line, but we made it because we thought it was the right thing to do," Posner says.

Merck initially communicated the changes to all 4,000 employees through a series of documents e-mailed in early 2004. The company followed up by holding approximately 100 town hall meetings at its facilities around the country. Seminars were run by an outside financial-advisory firm because "they could bring expertise to the table, and were viewed as objective in the information they provided," Posner says. The two-hour seminars included a formal presentation and Q&A sessions where the consultants and Merck compensation department officials fielded questions.

Today, Posner is preparing to roll out the new compensation program to 1,100 Merck managers outside the United States, a task that had to wait until the company cleared legal and regulatory hurdles in some 90 countries. After that, the compensation team will begin weighing which of the company’s remaining 50,000 employees who are eligible to receive options will be next.

Not all companies are dropping options and replacing them with something else. One company that unapologetically cut options without adding another type of benefit is Sears, Roebuck and Co. In January, Sears announced an overhaul meant to put it on a par with Wal-Mart and other rivals. Beginning in 2005, Sears will phase out its pension plan, reduce bonuses, increase pay for hourly workers and drastically cut options. Previously, all of Sears’ 17,000 salaried employees were eligible to receive options. Starting next year, only 2,500 employees at the director level or above will be eligible, says Chris Brathwaite, a Sears spokesman. "Most retail companies do not make annual stock-option grants to all salaried associates," Brathwaite says. "To succeed and grow, we needed to be more competitive."

But at other companies, the appeal of stock options hasn’t dimmed, despite industry trends. Costco Wholesale Corp. grants options to about 1,200 store managers and buyers annually or biannually. That didn’t change even after the $42 billion warehouse retailer began expensing options in 2002. The Issaquah, Washington, company estimated that in fiscal 2003, expensing options decreased pre-tax income by 1 percent.

If Costco were to modify anything, it would be to add RSUs or performance-based shares to options, but not to cut the number of managers eligible to receive them, says Richard Galanti, Costco chief financial officer. "Historically, senior management’s philosophy has been that having some skin in the game is positive," Galanti says.